Hedge funds emerge as market force

Less than two years ago, if financial planners talked about hedge funds it would have been no great surprise if investors thought the alternative investment was linked to gnomes and gardening products.

However, after the technology stocks and their dot.com counterparts went belly up and lost substantial favour with investors, hedge funds emerged a slightly older, and less gnome-like asset class.

Today, hedge funds are part of the portfolio pack, with financial planners eager to offer their clients alternative investments outside the commercial norm.

So how have hedge funds managed to emerge from such humble beginnings to become a more popular investment class?

Absolute Capital head of distribution Joshua Goben attributes the change in hedge funds appeal to a number of key factors.

“The primary driver has been product development, and the requirements for investors of all types to move from a relative return mindset to an absolute return mindset,” he says.

“There has also been the proliferation of brand name, with traditional managers setting up investment advisory arrangements with the US and European fund of hedge fund providers to offer products in the domestic market,” Goben says.

Hedge Funds of Australia managing director Spencer Young attributes the change in the popularity of hedge funds to historical factors.

Young says a large percentage of investors today would not have been investing in the market in 1987, which experienced a market collapse, and so haven’t experienced any market scares. This, he says, enables investors to try different things.

“Markets don’t always go up, sometimes they go down, and go down for a long period of time,” Young says.

“Consistent, reasonable terms deliver a much greater return. Last month, international shares were down 20 per cent with diversified funds up six per cent. Next year, the stock market investor needs to be up 50 per cent to get to where we are,” he says.

Basis Capital joint managing director Stuart Fowler says the hedge fund sector has experienced substantial growth and interest through the awareness by investors that the funds can generate positive returns even when traditional asset classes are going south.

“Traditional funds are often limited by strict limitations on, for example, short-selling of stocks, borrowing money to leverage investors’ returns or use of derivatives like interest rate swaps,” Fowler says.

He says hedge funds should be neutralising as much pure market directional risk as possible. The funds should also be employing some leverage and being paid for performance, which aligns the investor with the hedge fund manager.

He says investors, through their financial planners, are beginning to realise the diversification benefits of allocating a small part of their portfolio to hedge funds.

“General thinking is that hedge funds, as an alternative asset class, should make up between five and 15 per cent of an investor’s portfolio,” Fowler says.

“They should also offer better risk-adjusted returns,” he says.

The notion that investors have boosted the popularity of hedge funds is not a view Goben shares. He believes the opposite — that hedge funds are not popular with investors.

Goben says there is a long way to go before investors at every level in the market truly understand the different returns hedge funds can provide.

“Perhaps the reason for recent improved credibility for the hedge fund sector is the robustness of returns through extremely volatile financial markets. Fund of hedge funds, through strategic asset allocation and sensible portfolio construction, have been able to demonstrate over the past two years the ability to preserve capital in declining equity conditions, and also generate positive returns,” he says.

Does this mean hedge funds are close to reaching their peak?

“No. Hedge funds are an umbrella term for a multitude of skill-based investment strategies,” Goben says.

Young agrees with Goben that the hedge fund sector still has a long way to travel.

“We’re on the edge. We see new advisers embracing what we’re doing. It’s not just us out there — Colonial is pushing the message as well — and now we’ve got Suncorp behind us, which also helps,” he says.

On a global scale, Fowler says hedge funds reputedly have about US$500 billion capital invested in them, which is the equivalent to less than one per cent of the market capitalisation of the global stock markets. So, according to Fowler, hedge funds have far from peaked.

He says hedge funds will also continue to adjust to prevailing market conditions.

“Opportunities in the hedge fund market will continually close and others open. For example, on a recent trip to New York, one expert investor said that she had seen hedge fund recessions, like the dearth of merger arbitrage opportunities at the moment because of the lack of mergers and acquisitions activity in the market. But this means, however, that hedge fund investors need to look at other geographies, sub-markets or emerging markets for hedge fund opportunities,” he says.

As for the future of this alternative investment, the years ahead for hedge funds look promising, Young says.

With the market instability of the 1980s now more than 15 years ago, and with 2001/02 still fresh in investors’ minds, he believes alternative investments, particularly hedge funds, will not be a bad place to be in the next five years.

“[As for future developments] listing of a hedge fund is just one option to provide some more liquidity, which is fine. But at the end of the day the key thing is not liquidity,” Young says.

Fowler says the future of hedge funds is forging greater customer alliances with investors through pushes for greater awareness of the products at market.

“Historically and typically overseas, hedge funds were for the wealthy in private banks and for institutions, but greater acceptance and awareness will mean tapping into investors in the traditional ways — by way of retail offerings of units or listing of the funds on the Australian Stock Exchange and more esoteric ways like instalment warrants and derivatives,” he says.